Reform the tax system, urges review

The government should consider a broad reform of the UK tax system, including an extension to the number of goods on which VAT is charged, a think tank has argued.

The Institute for Fiscal Studies (IFS) said that the change would streamline the current indirect taxation system and would generate extra income for the Exchequer.

The proposal forms part of a comprehensive report drawn together under the chairmanship of Nobel laureate, Sir James Mirrlees.

The aim of the review was to outline the future direction that the UK's tax system should take, and it set out a series of principles which could underpin a more coherent approach to taxation.

It said that the system should be designed as a whole, in conjunction with the benefits system, and that it needs to be green and to be progressive but that not every tax should be green or progressive.

The tax regime should also be neutral because taxes that distort people's behaviour by treating similar activities differently tend to create inefficiency, complexity and opportunities for avoidance.

And the system should be made as progressive as possible, a reform that would entail relying on the rate schedule of personal taxes and benefits - rather than inefficiently distorting the tax base - to achieve redistribution.

VAT was one of the specific areas that the review examined. It pointed out that the UK applies a zero rate of VAT to far more goods and services than most other countries.

VAT is charged at different rates according to the product or service. The top rate is 17.5 per cent but will climb to 20 per cent on 4 January next year.

A number of items, however, are charged at a VAT rate of 5 per cent, including domestic gas and electricity, while others, such as children's clothing, food and books, are taxed at 0 per cent.

The review described the discrepancies as an "expensive and highly inefficient" way of helping people on low incomes.

Instead, VAT should be extended to nearly all spending as this would reduce complexity and avoid distortions to consumption choices. The money raised could then be invested in cutting income taxes and raising benefits in a way that is broadly neutral.

The review also questioned the nature of the UK's direct taxation, saying that it is "opaque" and complicated, using, as it does, two separate taxes on earnings: income tax and national insurance contributions.

In the view of the report, the rate structure of income tax should be simplified, and income tax and NICs should be merged.

Business taxes came under scrutiny too.

Corporation tax, the report claimed, works against equity investment but promotes debt finance. And there is extra complexity because profits are taxed at different rates, and corporation tax is not properly integrated with personal taxes.

As an answer, the review proposed that a special allowance for corporate equity should be introduced into corporation tax. This would ensure an equal treatment of equity- and debt-financed investments and that only profits above the normal return to capital invested would be taxed. It was claimed that such a move could increase national income by 1.4 per cent (more than £20 billion at current prices).

The tax system as it applies to savings requires major change as well, the review said.

Different forms of saving are currently subject to different tax rules, while constant efforts to reform capital gains tax have illustrated the ongoing problems that exist in this part of the tax system.

To simplify matters, the IFS report suggested that, in order to boost savings levels, ordinary bank and building society savings accounts should be entirely free of tax.

When it comes to substantial holdings of risky assets, only returns, such as income and capital gains, above the 'normal' rate should be subject to tax at the same rate schedule as earned income (including NICs), with reduced rates for dividends and capital gains on shares to reflect the corporation tax already paid. Equalising the marginal tax rates on earnings and different forms of capital income would, the report argued, reduce distortions between different economic activities.

The review noted that environmental taxes are becoming an increasingly important element of the system but also highlighted that there are a number of different tax rates as they apply to carbon emissions. Road fuel tax is currently very high but will become less effective as the UK slowly switches to greener forms of transport.

There should, therefore, be a consistent price on carbon emissions, perhaps managed through a broader application of the EU Emissions Trading Scheme and a tax on other emission sources (including a tax on domestic gas consumption). Fuel duty, which does little to decongest the roads, should be replaced by a comprehensive system of congestion charges.

The review is an independent study, and there is no suggestion the government will act on its recommendations.

Sir James Mirrlees said: "The review shows that the UK system falls short of the ideal in costly and inequitable ways. It discourages saving and investment, and distorts the form they take.

"It favours corporate debt over equity finance. It fails to deal effectively with either greenhouse gas emissions or road congestion. The revenue it raises, and the redistribution it does, could be achieved in less costly ways.

"We propose both a long-term vision of a better system, and directions for reform. Some of the recommended reforms involve tweaks to current policy; others involve radical change, and are probably for the longer term. It is undeniable that some of the proposed changes would be politically difficult. But failure to reform imposes enduring costs."